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Overdiversification: Building Your Own High-Cost Mutual Fund

Does this sound like anybody you know?

  • 401(k) at current job: 5 mutual funds
  • 401(k) still with previous employer: 4 mutual funds
  • IRA: 3 mutual funds, handful of stocks
  • spouse’s 401(k) at current job: 5 mutual funds
  • Spouse’s IRA: 4 mutual funds, another handful of stocks

Grand total: Somewhere from 15-25 different mutual funds and a seemingly random assortment of stocks.

What’s the Problem?

What this person has amassed is the equivalent of an index fund, with the noteworthy difference that the fees being paid are the higher fees that come with actively managed funds. (That is, this person is probably paying 1.5%-2.5% in fees per year rather than 0.2% per year.)

People invest in actively-managed funds with the hope that the fund manager(s) can outperform the market. While there’s less than a 50% probability that a fund manager can beat the market, it’s certainly not impossible. The problem, however, is that once you own more and more actively-managed funds, the chance of them–in total–beating the market becomes more and more slim.

Imagine this scenario:

  • You’re flipping a coin.
  • Heads means your fund beats the market. Tails means your fund underperforms the market.
  • However, this coin is a trick coin, and it comes up tails 55% of the time.

Of course, if you only have to flip the coin once per year, your chance of beating the market is 45%. Not great, but not awful. But if you have to flip the coin 15 times each year (ie, you own 15 actively-managed funds), your chance of coming out ahead is significantly lower than 45%.

Or to look at it without using hypothetical coin flip scenarios, just consider this: The way that a fund manager hopes to outperform the market is by over or underweighting certain stocks (or certain sectors or asset classes) when they feel it’s advantageous.

Unfortunately, the more funds you own, the more likely it is that some of the managers are taking completely opposite strategies, thereby cancelling out any potential advantage to be gained, but still leaving you with the higher cost.

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